4/08/2010 @ 11:20AM

The Proposed New Financial Regulation Could Backfire

Starting in February credit card companies were barred from a variety of dastardly practices, including jacking up interest rates without notice or when a consumer stiffs a different creditor. But well before the law kicked in, card issuers were maneuvering to protect themselves. They started cutting back on credit to their riskiest customers early last year. Between December 2008 and July 2009, a Pew Charitable Trusts study shows, the biggest card issuers raised their lowest rates by a fifth.

So much for protecting the consumer. It’s the law of unintended consequences: Tighten the screws on companies in a competitive business and they’ll figure out another way to make a buck. Expect a furious new round of maneuvering–along with higher costs and less credit–if Congress enacts a sweeping financial reform law that would create a czar to pass judgment on financial products nationwide.

The 1,336-page bill sponsored by Senator Christopher Dodd (D–Conn.) would establish a Bureau of Consumer Financial Protection within the Federal Reserve, which could levy fines of up to $1 million a day against companies that engage in “unfair, deceptive or abusive acts or practices.”

What’s an unfair or abusive act? That depends on the eye of the regulator. One indicator in the bill: “consumer financial products with high growth rates” that pose risks that might not be understood by an “ordinary consumer.” In an earlier era might that have included innovative new products like the universal credit card, introduced by
Bank of America
in 1958? Or money market mutual funds, which siphoned off bank deposits in the 1970s?

The new consumer finance agency is based on an emerging school of “behavioral economics” that assumes consumers can’t make good financial decisions on their own. This theory is championed by, among others, Elizabeth Warren, a Harvard Law School professor and chairman of the Congressional Oversight Panel on financial markets, and Michael S. Barr, assistant Treasury secretary. They believe some financial products are inherently defective, as dangerous to the public as exploding toasters and crumpling car seats.

Barr says he doesn’t want to have the government preapprove financial products, the way it does prescription drugs. Rather, he wants a regulator who can crack down on bad products after they are on the market. The czar might order mortgage brokers, say, to disclose all the risks of a pick-a-pay, adjustable-rate mortgage whose payments become unaffordable a few years after the papers are signed.

“What if a broker had a duty of affordability?” Barr asks. “A [consumer protection agency] could require that.”

No question consumers do dumb things. An influential paper by Warren and Oren Bar-Gill of New York University School of Law lists a few: 90% of consumers keep cash in low-yielding deposit accounts that they could use to pay off high-interest credit card balances. A majority of consumers fail to move their balances to a new card after a low “teaser” introductory rate expires. It is the rare consumer who shops for cards with low late fees, because most assume they will send in their payments on time.

Backfires in other markets offer a warning. Merchants have protested for years against the so-called interchange fees that are subtracted from the proceeds of a credit card sale. But when Australia’s central bank limited them in 2004, a U.S. General Accountability Office study shows, merchants failed to pass on the savings, estimated at $920 million a year, and card issuers doubled annual fees.

Another experiment is state bans on payday loans–the practice of charging an upfront fee for cashing postdated checks. New York Federal Reserve researcher Donald Morgan has shown that after Georgia made such loans a criminal offense in 2004, bounced checks at the Atlanta Fed rose 13%, generating $36 million in additional income for banks.

Two bounced $75 checks (the national average is $66) at $29 apiece equals an annual interest rate of 1,000%, versus 300% for the typical payday loan. But banks got 21% of their operating profit from bounced-check fees in 2008, and credit unions got 60%, according to the Federal Deposit Insurance Corp. Will a superregulator define these fees as “abusive”?

Many states used to regulate consumer finance through usury laws restricting maximum interest rates. That meant consumers got 60% or more of their finance from retailers, who frequently marked up the price of goods to compensate for the risk of not getting repaid.

The new czar’s broad powers and the tendency of regulators to do the bidding of the largest institutions under their control worry David John, a regulatory expert at the conservative Heritage Foundation. “It can be used very easily to cement the financial services status quo,” John says. Another likely winner: lawyers. The broad language of the proposed statute is an invitation for regulatory overreach. That’s usually followed by expensive litigation, says John McGuinness, a financial services lawyer with Kelley Drye & Warren in Washington.

One premise behind all this regulation is that consumers suffer from an information asymmetry: They don’t know enough to get the best terms from lenders. But consumers aren’t always victims. According to the Nilson Report, credit card company charge-offs–money spent on shoes and groceries and television sets that will never be repaid–totaled at least $313 billion over the last decade.